Norm Champ has been on the job as Director of the Division of Investment Management at the Securities and Exchange Commission for eight months and a lot of mutualfund executives are nervously waiting for the SEC has in store for the industry in 2013 and beyond.

Why Is Saving for Retirement So Hard?

This month's article is the sixth in a series called "Behavioral Finance and Retirement," which is intended to provide insight to advisors on the unique needs and financial behaviors of clients who are entering that period of transition called "retirement."

I put retirement in quotation marks because people today are not retiring the way they used to. The days of the retirement party, the gold watch, and sitting out one's years doing crossword puzzles and watching "Wheel of Fortune" are over for most people.

We've all heard the analogy that the baby boomers are like a baseball going through a garden hose. Well, the baseball is getting to the end of the hose, and it's not leaving without a bang! And before it leaves, it will be a financial force to be reckoned with.

To serve retired clients properly, there are some key themes that advisors need to be aware of:

1. People are living longer than ever thanks in part to medical technology and better living habits such as diet and exercise. This is extending the length of time people are in a nonworking phase of life.

2. People's definition of retirement is changing, which is having a major impact on how individuals manage their finances.

3. In some cases, a certain segment of the population will have no choice but to produce some type of income after they leave the traditional workforce.

4. The responsibility of planning and investing for retirement has shifted in large part to the employee/retiree and away from corporations. As a result, behavioral biases significantly affect individuals who are entering or already in this phase of life.

Self-Control Bias and Saving HabitsIn this article we are going to turn our attention to the biases that affect investment choices in the retirement planning process. The right place to start, of course, is the most fundamental aspect of retirement planning: saving.

According to the life-cycle theory of investing (more on this later) people will attempt to accumulate assets for retirement that will be sufficient to protect them from unexpected declines in their standard of living as they age. However, people have a difficult time implementing a long-term saving plan. Naturally, if you can't save, you will not have a reason to even plan. So we will first discuss the behavioral biases involved with saving. Once you get a feel for the behaviors driving this key issue, you will be in a much better position to advice your clients.

Lets start with a key question: How good are people at figuring out how much they need for their retirement?

Based on the evidence presented earlier in this series, it appears the answer is "not very good." Why is this? As I have discussed in my CFA curriculum readings, in large measure the retirement-savings problem is tied to the idea of "bounded rationality." This means that people have trouble estimating complex math problems--in this case they have trouble estimating retirement needs. To do so, one needs to be good at estimating an entire lifetime of work earnings, the aftertax returns on their investments, their health status, and their lifespan--all of which are uncertain to be sure. My friend Annamaria Lusardi's empirical research demonstrates that individuals are not particularly good at the retirement savings problem. She has demonstrated that there are not many workers out there who are able to plan effectively for their retirement.

So what is the main behavioral bias at work here? The explanation is simple: a lack of willpower or what I call self-control bias. The technical description of self-control bias is best understood in the context of the life-cycle hypothesis, which describes a well-defined link between the savings and consumption tendencies of individuals, and those individuals' stages of progress from childhood through years of work participation and finally into retirement.

The foundation of the model is the saving decision, which directs the division of income between consumption and saving. The saving decision reflects an individual's relative preferences over present versus future consumption. Because the life-cycle hypothesis is firmly grounded in expected utility theory and assumes rational behavior, an entire lifetime's succession of optimal saving decisions can be computed given only an individual's projected household income stream vis-à-vis the utility function.

The income profile over the life cycle starts with low income during the early working years, followed by increasing income that reaches a peak prior to retirement. Income during retirement, based on assumptions regarding pensions, is then substantially lower. To make up for the lower income during retirement and to avoid a sharp drop in utility at the point of retirement, individuals will save some fraction of their income when they're still working, spending it later, during retirement.

The main prediction, then, of the life-cycle hypothesis is a lifetime savings profile characterized by a "hump"-shaped curve, with savings building gradually, maxing out, and finally declining again as a function of time. Basically, the life-cycle hypothesis envisions that people will try to maintain the highest, smoothest consumption paths possible.

It would seem that while people intellectually "understand" the benefits of a specific behavior, and they may even have some idea of how to get started, they have difficulty implementing their intentions. Too often, they struggle to take action, and when they do act, their behaviors are often half-hearted or ineffective.

Counteracting Self-Control BiasWhen a practitioner encounters self-control bias, there are four primary topics on which advice can generally be given: 1) spending control, 2) lack of planning, 3) portfolio allocation, and 4) the benefits of discipline.

Spending control. Self-control bias can cause investors to spend more today rather than saving for tomorrow. People have a strong desire to consume freely in the present. This behavior can be counterproductive to attaining long-term financial goals, because retirement often arrives before investors have managed to save enough money. This may spur people into accepting, at the last minute, inordinate amounts of risk in their portfolios to make up for lost time--a tendency that actually places one's retirement security at increased risk. Advisors should counsel their clients to pay themselves first, setting aside consistent quantities of money to ensure their comfort later in life, especially if retirement is still a long way off.

If an advisor encounters investors who are past age 60 and have not saved enough for retirement, then a more difficult situation emerges. A careful balance must be struck between saving, investing, and risk-taking in order to increase the pot of money for retirement.

Often, these clients might benefit from examining additional options, such as part-time work (cycling in and out of retirement) or cutting back on consumption. In either case, emphasizing paying oneself first--assigning a sufficient level of priority to future rather than present-day consumption--is critical.

Lack of planning. Self-control bias may cause investors to not plan adequately for retirement. Studies have shown that people who do not plan for retirement are much less likely to retire securely than those who do plan. People who do not plan for retirement are also less likely to invest in equity securities.

Advisors must emphasize that investing without planning is like building without a blueprint. Planning is the absolute key to attaining long-term financial goals. Furthermore plans need to be written down so that they can be reviewed on a regular basis. Without planning, investors may not be apt to invest in equities, potentially preventing them from keeping up with inflation. In sum, people don't plan to fail--they simply fail to plan.

Portfolio allocation. Self-control bias can cause asset allocation imbalance problems. Investors subject to this bias may prefer income-producing assets, due to a "spend today" mentality. This behavior can be counterproductive to attaining long-term financial goals because an excess of income-producing assets can prevent a portfolio from keeping up with inflation. Self-control bias can also cause people to unduly favor certain asset classes, such as equities over bonds, due to an inability to rein in impulses toward risk.

Advisors must emphasize the importance of adhering to a planned asset allocation. There is a litany of information on the benefits of asset allocation, which can be persuasively cited for a client's benefit. Whether they prefer bonds or equities, clients exhibiting a lack of self-control need to be counseled on maintaining properly balanced portfolios so that they can attain their long-term financial goals.

Benefits of discipline. Self-control bias can cause investors to lose sight of very basic financial principles, such as the compounding of interest or dollar-cost averaging. By failing to reap these "discipline profits" over time, clients can miss opportunities for accruing significant long-term wealth.

Perhaps the most critical issue is to counsel your clients on the benefits of compounding. There are a number of very effective software programs that can demonstrate how even a minimal 1% to 2% disparity in returns, if compounded over decades, can mean the difference between a comfortable and a subpar retirement.

To return to an example that arises frequently in discussions of willpower--the matter of exercising--the benefits of self-discipline in investing, as in physical fitness, are difficult to obtain. The results, however, are well worth it.

Next month we will continue the discussion about behavioral biases in retirement.